Sampa Video, Inc. was the second largest chain of videocassette rental stores in the greater Boston area, operating 30 wholly owned outlets. Begun in 1988 as a small store in Harvard Square catering mostly to students, the company grew rapidly, primarily due to its reputation for customer service and an extensive selection of foreign and independent movies. These differentiating factors allowed Sampa Video to compete directly with the leader in the industry, Blockbuster Video. But unlike the larger rival, Sampa had no ambitions to grow outside of its Boston territory. Exhibit i contains summary financial information on the company as of their latest fiscal year-end. In March 2001, Sampa Video was considering entering the business of home delivery of movie rentals. The company would set up a web page where customers could choose movies based on available in-store inventory and pick a time for delivery. This would put Sampa in competition with new internet-based competitors, such as Netflix.com that rented DVDs through the mail and Kramer.com and Cityretrieve.com that hand delivered DVDs and videocassettes. While it was expected that the project would cannibalize the existing operations to some extent, management believed that incremental sales would be substantial in the long run. The project would provide customers the same convenience as internet-based DVD rentals for the wider selection of movies available on videocassettes. Sampa also planned to hand deliver DVDs. The company expected that the project would increase its annual revenue growth rate from 5% to 10% a year over the following 5 years. After that, as the home delivery business matured, the free cash flow would grow at the same 5% long-term rate as the videocassette rental industry as a whole. Exhibit 2 contains management's projections for the expected incremental revenues and cash flows achievable from the project. Sampa management's major concern was the significant up-front investment required to start the project. This consisted primarily of setting up a network of delivery vehicles and staff, developing the website, and some initial advertising and promotional efforts to make existing customers aware of the new service Management estimated these costs at $1.5 million, all of which would be incurred in December 2001, as the service would be launched in January 2002.1 Management was debating how to assess the project's debt capacity and the impact of any financing decisions on value. In thinking about how much debt to raise for the project, two options were being considered. The first was to fund a fixed amount of debt, which would either be kept in perpetuity or paid down gradually. The second alternative was to adjust the amount of debt so as to 1 For the purposes of this exercise, it is assumed that all start-up costs would have been capitalized, and depreciated over time. In reality, some of these costs would have been capitalized (e.g., investment in delivery vehicles) while others would have been expensed immediately le.g., advertising costs). Exhibit 1 Summary Financial Information on Sampa Video, Inc., 2000 (in thousands of dollars) Sales EBITDA Depreciation Operating Profit Net Income FY 2000 22,500 2,500 1,100 1,400 660 Source: Casewriter estimates. aEBITDA is the Earnings Before Interest, Taxes, Depreciation and Amortization. Exhibit 2 Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-2006 (in thousands of dollars). 2002E 1,200 2003E 2,400 2004E 3,900 2005E 5,600 2006E 7,500 Sales 840 360 (225) (275) EBITDA Depreciation EBIT Tax Expense EBIAT a 180 (200) (20) 8 (12) 135 585 (250) 335 (134) 201 565 1,125 (300) 825 (330) 495 (54) 81 (226) 339 CAPXb Investment in Working Capital 300 0 300 0 300 0 300 0 300 0 Source: Casewriter estimates. aEBITD is the Earnings Before Interest, Taxes and Depreciation. EBIAT is the Earnings Before Interest and After Taxes. Taxes calculated assuming no interest expense. bAnnual capital expenditures of $300,000 were in addition to the initial $1.5 million outlay, and are assumed to remain constant in perpetuity. Exhibit 3 Additonal Assumptions. Risk-free Rate (R) Project Cost of Debt (R.) Market Risk Premium Marginal Corporate Tax Rate Project Debt Beta (Pd) Asset Beta for Kramer.com and Cityretrieve.com 5.0% 6.8% 7.2% 40% 0.25 1.50 Source: Casewriter estimates. Sampa Video Case Study Questions 1. What are the annual projected free cash flows? 2. What is the value of the project assuming the firm was entirely equity financed? 3. What is the value of the project using the Adjusted Present Value (APV) approach, assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity? 4. How does your answer for question 3 changes if the firm must pay the debt at the end of the project life at the end of 2006)? 5. Value the project using the Weighted Average Cost of Capital (WACC) approach assuming the firm maintains a constant 25% debt-to-market value ratio in perpetuity 6. Value the project using the Flow to Equity (FTE) approach assuming the firm raises 750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity? 7. How does your answer for question 6 changes if the firm must pay the debt at the end of the project life at the end of 2006)? 8. How do the values from the all equity (question 2), APV (question 3), WACC (question 5), and FTE (question 6) approaches compare? How do the assumptions about financial policy differ across the three approaches? NOTE: In all cases, compute the Terminal Value (located at 2006) as: CF 2006(1 +5.00%) Discount Rate - 5.00% Sampa Video, Inc. was the second largest chain of videocassette rental stores in the greater Boston area, operating 30 wholly owned outlets. Begun in 1988 as a small store in Harvard Square catering mostly to students, the company grew rapidly, primarily due to its reputation for customer service and an extensive selection of foreign and independent movies. These differentiating factors allowed Sampa Video to compete directly with the leader in the industry, Blockbuster Video. But unlike the larger rival, Sampa had no ambitions to grow outside of its Boston territory. Exhibit i contains summary financial information on the company as of their latest fiscal year-end. In March 2001, Sampa Video was considering entering the business of home delivery of movie rentals. The company would set up a web page where customers could choose movies based on available in-store inventory and pick a time for delivery. This would put Sampa in competition with new internet-based competitors, such as Netflix.com that rented DVDs through the mail and Kramer.com and Cityretrieve.com that hand delivered DVDs and videocassettes. While it was expected that the project would cannibalize the existing operations to some extent, management believed that incremental sales would be substantial in the long run. The project would provide customers the same convenience as internet-based DVD rentals for the wider selection of movies available on videocassettes. Sampa also planned to hand deliver DVDs. The company expected that the project would increase its annual revenue growth rate from 5% to 10% a year over the following 5 years. After that, as the home delivery business matured, the free cash flow would grow at the same 5% long-term rate as the videocassette rental industry as a whole. Exhibit 2 contains management's projections for the expected incremental revenues and cash flows achievable from the project. Sampa management's major concern was the significant up-front investment required to start the project. This consisted primarily of setting up a network of delivery vehicles and staff, developing the website, and some initial advertising and promotional efforts to make existing customers aware of the new service Management estimated these costs at $1.5 million, all of which would be incurred in December 2001, as the service would be launched in January 2002.1 Management was debating how to assess the project's debt capacity and the impact of any financing decisions on value. In thinking about how much debt to raise for the project, two options were being considered. The first was to fund a fixed amount of debt, which would either be kept in perpetuity or paid down gradually. The second alternative was to adjust the amount of debt so as to 1 For the purposes of this exercise, it is assumed that all start-up costs would have been capitalized, and depreciated over time. In reality, some of these costs would have been capitalized (e.g., investment in delivery vehicles) while others would have been expensed immediately le.g., advertising costs). Exhibit 1 Summary Financial Information on Sampa Video, Inc., 2000 (in thousands of dollars) Sales EBITDA Depreciation Operating Profit Net Income FY 2000 22,500 2,500 1,100 1,400 660 Source: Casewriter estimates. aEBITDA is the Earnings Before Interest, Taxes, Depreciation and Amortization. Exhibit 2 Projections of Incremental Expected Sales and Cash Flows for Home Delivery Project 2002-2006 (in thousands of dollars). 2002E 1,200 2003E 2,400 2004E 3,900 2005E 5,600 2006E 7,500 Sales 840 360 (225) (275) EBITDA Depreciation EBIT Tax Expense EBIAT a 180 (200) (20) 8 (12) 135 585 (250) 335 (134) 201 565 1,125 (300) 825 (330) 495 (54) 81 (226) 339 CAPXb Investment in Working Capital 300 0 300 0 300 0 300 0 300 0 Source: Casewriter estimates. aEBITD is the Earnings Before Interest, Taxes and Depreciation. EBIAT is the Earnings Before Interest and After Taxes. Taxes calculated assuming no interest expense. bAnnual capital expenditures of $300,000 were in addition to the initial $1.5 million outlay, and are assumed to remain constant in perpetuity. Exhibit 3 Additonal Assumptions. Risk-free Rate (R) Project Cost of Debt (R.) Market Risk Premium Marginal Corporate Tax Rate Project Debt Beta (Pd) Asset Beta for Kramer.com and Cityretrieve.com 5.0% 6.8% 7.2% 40% 0.25 1.50 Source: Casewriter estimates. Sampa Video Case Study Questions 1. What are the annual projected free cash flows? 2. What is the value of the project assuming the firm was entirely equity financed? 3. What is the value of the project using the Adjusted Present Value (APV) approach, assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity? 4. How does your answer for question 3 changes if the firm must pay the debt at the end of the project life at the end of 2006)? 5. Value the project using the Weighted Average Cost of Capital (WACC) approach assuming the firm maintains a constant 25% debt-to-market value ratio in perpetuity 6. Value the project using the Flow to Equity (FTE) approach assuming the firm raises 750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity? 7. How does your answer for question 6 changes if the firm must pay the debt at the end of the project life at the end of 2006)? 8. How do the values from the all equity (question 2), APV (question 3), WACC (question 5), and FTE (question 6) approaches compare? How do the assumptions about financial policy differ across the three approaches? NOTE: In all cases, compute the Terminal Value (located at 2006) as: CF 2006(1 +5.00%) Discount Rate - 5.00%